Because learning changes everything.

Corporate Finance
Thirteenth Edition
Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe /
Bradford D. Jordan

Chapter 2

Financial Statements and Cash Flow

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
 Key Concepts and Skills
• Understand the information provided by financial
statements.
• Differentiate between book and market values.
• Know the difference between average and marginal
tax rates.
• Know the difference between accounting income and
cash flow.
• Calculate a firm’s cash flow.

© McGraw Hill, LLC 2

 Chapter Outline
2.1 The Balance Sheet.
2.2 The Income Statement.
2.3 Taxes.
2.4 Net Working Capital.
2.5 Cash Flow of the Firm.
2.6 The Accounting Statement of Cash Flows.
2.7 Cash Flow Management.

© McGraw Hill, LLC 3

 Sources of Information
Annual reports.
Wall Street Journal.
Internet.
• NYSE (www.nyse.com)
• Nasdaq (www.nasdaq.com)
• Textbook (www.mhhe.com)

SEC.
• EDGAR.
• 10K & 10Q reports.

© McGraw Hill, LLC 4

 2.1 The Balance Sheet
An accountant’s snapshot of the firm’s accounting value at a
specific point in time
The Balance Sheet Identity is:

Assets  Liabilities  Stockholders' equity

© McGraw Hill, LLC 5

 The Balance Sheet of the U.S. Composite
Corporation 1

The assets are listed in order by the length of time it would normally take
a firm with ongoing operations to convert them into cash.
Clearly, cash is much more liquid than property, plant, and equipment.

Access the text alternative for slide images

© McGraw Hill, LLC 6
 Balance Sheet Analysis
When analyzing a balance sheet, the financial manager
should be aware of three concerns:
1. Liquidity.
2. Debt versus equity.
3. Value versus cost.

© McGraw Hill, LLC 7

 Liquidity
Liquidity refers to the ease and quickness with which assets
can be converted to cash—without a significant loss in value.
Current assets are the most liquid.
Some fixed assets are intangible.
The more liquid a firm’s assets, the less likely the firm is to
experience problems meeting short-term obligations.
Liquid assets frequently have lower rates of return than fixed
assets.

© McGraw Hill, LLC 8

 Debt versus Equity
Bondholders generally receive the first claim on the firm’s
cash flow.
Stockholders’ equity is the residual difference between
assets and liabilities.

© McGraw Hill, LLC 9

 Value versus Cost
Under generally accepted accounting principles (GAAP),
audited financial statements of firms in the U.S. carry assets
at cost.
Market value is the price at which the assets, liabilities, and
equity could actually be bought or sold, which is a completely
different concept from historical cost.

© McGraw Hill, LLC 10

 2.2 The Income Statement
Measures financial performance over a specific period of
time
The accounting definition of income is:

Revenue  Expenses  Income

© McGraw Hill, LLC 11

 The Income Statement of the U.S. Composite
Corporation - I

The operations
section of the
income statement
reports the firm’s
revenues and
expenses from
principal operations.

Access the text alternative for slide images

© McGraw Hill, LLC 12
 The Income Statement of the U.S. Composite
Corporation - II

The nonoperating
section of the
income statement
includes all financing
costs, such as
interest expense.

Access the text alternative for slide images

© McGraw Hill, LLC 13
 The Income Statement of the U.S. Composite
Corporation - III

Usually a separate
section reports the
amount of taxes
levied on income.

Access the text alternative for slide images

© McGraw Hill, LLC 14
 The Income Statement of the U.S. Composite
Corporation - IV

Net income is the

“bottom line.”

Access the text alternative for slide images

© McGraw Hill, LLC 15
 Income Statement Analysis
There are three things to keep in mind when analyzing an
income statement:
1. Generally Accepted Accounting Principles (GAAP)
2. Noncash Items.
3. Time and Costs.

© McGraw Hill, LLC 16

 GA AP
The matching principle of GAAP dictates that revenues be
matched with expenses.
Thus, income is reported when it is earned, even though no
cash flow may have occurred.

© McGraw Hill, LLC 17

 Noncash Items
Depreciation is the most apparent. No firm ever writes a
check for “depreciation.”
Another noncash item is deferred taxes, which does not
represent a cash flow.
Thus, net income is not cash.

© McGraw Hill, LLC 18

 Time and Costs
In the short run, certain equipment, resources, and
commitments of the firm are fixed, but the firm can vary such
inputs as labor and raw materials.
In the long run, all inputs of production (and hence costs) are
variable.
Financial accountants do not distinguish between variable
costs and fixed costs. Instead, accounting costs usually fit
into a classification that distinguishes product costs from
period costs.

© McGraw Hill, LLC 19

 2.3 Taxes
The one thing we can rely on with taxes is that they are
always changing.
• Tax Cuts and Jobs Act of 2017.
• See the IRS website for current information.

Average versus marginal tax rates.

the tax bill
Average 
taxable income
• Marginal: Percentage paid on the next dollar earned.

Other taxes

© McGraw Hill, LLC 20

 Average versus Marginal Rates
Suppose your firm earns $4 million in taxable income.
• What is the firm’s tax liability?
• What is the average tax rate?
• What is the marginal tax rate?
If you are considering a project that will increase the firm’s
taxable income by $1 million, what tax rate should you use in
your analysis?

© McGraw Hill, LLC 21

 2.4 Net Working Capital

Net Working Capital  Current Assets  Current Liabilities

NWC usually grows with the firm.

© McGraw Hill, LLC 22

 The Balance Sheet of the U.S. Composite
Corporation 2

Access the text alternative for slide images

© McGraw Hill, LLC 23
 2.5 Cash Flow of the Firm
In finance, the most important item that can be extracted
from financial statements is the actual cash flow of the firm.
Since there is no magic in finance, it must be the case that
the cash flow received from the firm’s assets must equal the
cash flows to the firm’s creditors and stockholders.

CF (A)  CF (B)  CF (S)

© McGraw Hill, LLC 24

 Financial Cash Flow of the U.S. Composite
Corporation - I

Access the text alternative for slide images

© McGraw Hill, LLC 25
 Financial Cash Flow of the U.S. Composite
Corporation - II

Access the text alternative for slide images

© McGraw Hill, LLC 26
 Financial Cash Flow of the U.S. Composite
Corporation - III

NWC grew from

$252 million in 2018
to $271 million in
2019.
This increase of $19
million is the
addition to NWC.

Access the text alternative for slide images

© McGraw Hill, LLC 27
 Financial Cash Flow of the U.S. Composite
Corporation - IV

Access the text alternative for slide images

© McGraw Hill, LLC 28
 Financial Cash Flow of the U.S. Composite
Corporation - V

Access the text alternative for slide images

© McGraw Hill, LLC 29
 Financial Cash Flow of the U.S. Composite
Corporation - VI

Access the text alternative for slide images

© McGraw Hill, LLC 30
 Financial Cash Flow of the U.S. Composite
Corporation - VII

The cash flow received from the firm’s assets must equal the cash flows
to the firm’s creditors and stockholders:
Access the text alternative for slide images
© McGraw Hill, LLC 31
 2.6 The Accounting Statement of Cash Flows

There is an official accounting statement called the statement

of cash flows.
This helps explain the change in accounting cash, which for
U.S. Composite is $41 million in 2022.
The three components of the statement of cash flows are:
• Cash flow from operating activities.
• Cash flow from investing activities.
• Cash flow from financing activities.

© McGraw Hill, LLC 32

 U.S. Composite Corporation Cash Flow from
Operating Activities
To calculate cash flow from Operations
operating activities, start Net income $ 86
with net income, add back Depreciation 90
noncash items like Deferred taxes 9
depreciation and adjust for Change in assets and liabilities
changes in current assets Accounts receivable −24
and liabilities (other than Inventories 11

cash). Accounts payable 35

Cash flow from operating activities $207

© McGraw Hill, LLC 33

 U.S. Composite Corporation Cash Flow from
Investing Activities
Cash flow from investing Acquisition of fixed assets −$198
activities involves changes Sales of fixed assets 25
in capital assets: acquisition Cash flow from operating activities −$173
of fixed assets and sales of
fixed assets (i.e., net capital
expenditures).

© McGraw Hill, LLC 34

 U.S. Composite Corporation Cash Flow from
Financing Activities
Cash flows to and from Retirement of long-term debt −$73
creditors and owners Proceeds from long-term debt sales 86
include changes in equity Dividends −43
and debt. Repurchase of stock −6
Proceeds from new stock issue 43
Cash flow from financing activities $ 7

© McGraw Hill, LLC 35

 U.S. Composite Corporation Statement of Cash
Flows

The statement of cash

flows is the addition of
cash flows from
operations, investing
activities, and
financing activities.

Access the text alternative for slide images

© McGraw Hill, LLC 36
 2.7 Cash Flow Management
Earnings can be manipulated using subjective decisions
required under GAAP.
Total cash flow is more objective, but the underlying
components may also be “managed”
• Moving cash flow from the investing section to the
operating section may make the firm’s business appear
more stable.

© McGraw Hill, LLC 37

 Quick Quiz
What is the difference between book value and market
value? Which should we use for decision-making purposes?
What is the difference between accounting income and cash
flow? Which do we need to use when making decisions?
What is the difference between average and marginal tax
rates? Which should we use when making financial
decisions?
How do we determine a firm’s cash flows? What are the
equations, and where do we find the information?

© McGraw Hill, LLC 38

 End of Main Content

Because learning changes everything. ®

www.mheducation.com

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.